LIBOR and a Line in the Ethical Sand

The Barclays LIBOR scandal suggests that no amount of compliance overlay can prevent systemic risk if unethical behaviour at the individual level is not clearly defined and nipped in the bud far earlier than we are used to seeing.

There seems no end to the queue of banking scandals. In quick succession, a London trader has cost JP Morgan somewhere between four and seven billon dollars. Barclays has been caught out fiddling LIBOR and HSBC has been helping drug runners. Earlier, a UBS trader cost the Swiss bank $2 billion by hiding unauthorised transactions. Even now, more of the banking majors are supposed to be in the crosshairs of regulators for LIBOR rigging.

The net impact of the attempts to rig LIBOR for the benefit of the Barclays trading desk remains unclear. We do not know whether other banks were acting in concert with Barclays or whether they were acting in their own interests, possibly even zigging when Barclays was zagging.

Who lost, if anyone, and by how much is yet to come out. Evidence given at hearings before the House of Commons Treasury Committee suggested that, in some cases, Barclays traders had been targeting a lower LIBOR outcome not the higher rate that could have raised everyone's mortgage payments.

Being able to multiply 1 basis point by three hundred trillion dollars, the total amount of lending analysts estimate is tied to LIBOR, is a handy journalistic artifice to whip up the crowd but does nothing to help us measure the actual impact.

That is not to say that examples of minor malfeasance should be ignored but there are two policy problems here which, unhelpfully, become intertwined.

The first is the macro issue of what impact Barclays or JP Morgan or HSBC has on the stability of the banking system or, even more broadly, the well being of nations. Tied to this is whether banks can be too big to manage and whether economies are enhanced by having access to giant financial supermarkets. These are largely technical questions subject to empirical analysis.

The second issue relates to what the broader community expects of its banks and their regulators.

Inappropriate behaviour becomes more obvious when it snowballs into multibillion dollar amounts but many of the financial scandals of recent years have started more modestly. The sub prime crisis in 2007-08, for example, had its beginnings among well meaning individuals who supported more widespread home ownership.

At some point, an apparently noble endeavour turned into something that risked the lives of millions of people (as a 1930s-style depression would have done).

Policymakers face a challenge in identifying gradations of inappropriate behaviour at the individual level and fine tuning their responses accordingly. Nonetheless, to effect any change, they need to micromanage their response because the problems that turn into macroeconomic threats so often begin with seemingly innocuous behaviour.

If a policeman standing in the rain outside a shop is invited into the shop until the rain stops, hardly anyone would object or insist he stand outside. Let's say that the weather is very hot and a shopkeeper offers the policeman a drink of water. Again, that appears innocent enough. But if the shopkeeper invites the policeman inside and gives him a hamburger and a drink, we are more likely to say that a line has been crossed.

It is tough to begrudge a hard working policeman an expression of gratitude. But once policemen become used to accepting gifts with even a modest value, the integrity of the police force could be jeopardised. At least perceptions of their honesty may be put at risk.

Inappropriate behaviour begins somewhere between a glass of water and a hamburger. Should the policeman be counselled not to take the glass of water, despite it being offered as an act of generosity, lest he risk stepping onto a slippery moral slide? That is the choice confronting public or private policymakers.

Watertight ethical outcomes will require very finely tuned moral antennae to discern the dividing lines between acceptable and unacceptable conduct.

Investors are left in a bind with limited options to protect their interests. They can demand more emphasis on individual ethical behaviour, including compulsory training in schools and ongoing professional development within a moral rather than technical context.

Even if the vast majority of traders cooperate, however, it would be well to rememberthat even one of the twelve apostles took an unauthorised silver position despite what seemed like leading edge compliance and ethical oversight at the time.

There is also a risk that multiple layers of compliance might simply create a false sense of confidence about how far behaviour has been modified and how confidently investors can approach markets.

There is a related issue. People employed to run a flawed system (e.g. Fannie Mae, LIBOR, the European monetary system) are going to react to the incentives they are given. That might not excuse individually unethical behaviour but the owners of LIBOR, Fannie Mae, the European currency and the JP Morgan chief investment office, for example, built systems that invited certain behaviours. There might be little point looking back to decry the inevitable outcomes unless the structures can also be dismantled.

Everyone, investors or not, might have to accept the likelihood that banks will throw off capital losses from time to time, sometimes even endangering national economic stability. Investing in even the best run financial institutions will need to take account of these periodic likely losses and occasional institutional failures. There may be no other choice without unrealistically prescriptive ethical standards and constraints on individual behaviour.

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